When I started writing this post, at about 2 p.m. EST, the Dow Jones Industrial Average was up about 150 points. If it had remained in positive territory, it would have marked the fifth straight day of a rising Dow, the longest such "winning streak" since November. However, that didn't happen. In fact, from the moment I started writing until the close of trading all the major stock market indexes fell steadily. The Dow ended up down 6.85 points.
Which makes the whole point of the post I had already completed -- wondering why investors had suddenly turned bullish -- moot. But I decided to publish it any way, with some new framing. (I promise not to make a habit of this.)
Even granting the late downturn on Monday, what can explain the relative bullishness of investors over the past week? Sure, Ben Bernanke predicted on 60 Minutes Sunday night that the U.S. would avoid another Great Depression, and even hinted that the process of economic recovery might begin later this year, but as Bernanke has forthrightly admitted, his economic forecasting record has been abysmal since the very first signs of stress emerged in the housing market. His prognostications seem a fragile reed upon which to base investment decisions. Similarly, financial stocks are surging because big banks like Citigroup and Bank of America and Barclays have reported profits for the first two months of 2009, but those profits do not take into account the vast liabilities represented by the trillions of dollars worth of toxic assets still on the books. Unemployment is rising steadily, home prices and car sales are in free fall and GDP growth in the first quarter of 2009 may even be worse than the fourth quarter of 2008: Goldman Sachs's chief economist Jan Hatzius suggests it may fall by as much 7 percent. Hardly a day goes by without a new, depressed, reading on some economic indicator -- on Monday morning, the Federal Reserve reported that U.S. industrial production dropped 1.4 percent, month-over-month, in February.
So what could Wall Street possibly be thinking? The economy sucks.
The first, and most obvious answer: Investors are deluded. We're witnessing a "dead cat bounce" -- a classic "bear market sucker's rally" built on desperation rather than based on fundamentals. One bad surprise from Citigroup tomorrow and all the gains of the past week could be wiped out in a single day.
But that's a boring answer. A more invigorating line of inquiry is to try to figure out just how we would know when the economy is bottoming out, and to see if the current landscape offers any inklings of hope. Stock markets tend to start rising well before a recession ends, so at some point the market is likely to rebound for real, and that could prefigure the return of economic growth.
Last week, Calculated Risk provided a useful summary of a 2007 paper, "Housing and the Business Cycle" by UCLA economist Ed Leamer, that outlines the typical order of problems that crop up during a typical recession:
The temporal ordering of the spending weakness is: residential investment, consumer durables, consumer nondurables and consumer services before the recession, and then, once the recession officially commences, business spending on the short-lived assets, equipment and software, and, last, business spending on the long-lived assets, offices and factories. The ordering in the recovery is exactly the same.
The key thing to understand: A collapse in residential housing, followed by a collapse in consumer spending, tends to usher an economy into recession. Likewise, their recovery tends to herald eventual economic rebirth. Calculated Risk argues that if you look at the overall GDP numbers for the fourth quarter of 2008 and the first quarter of 2007, the damage looks equally bad, but the composition of the damage is significantly different.
Most of the real GDP decline in Q1 will be from slumping investment and an inventory correction, whereas in Q4, declines in personal consumption (PCE) were an important contributor to the economic slump.
A great deal is riding here on whether the stabilization in retail spending that occurred in February is for real. If so, that might be the first sign that the typical business cycle is reasserting itself. But as I noted last week, there's still concern that rising unemployment will drag down consumer spending back down in the future. We're going to need more than just a decline that was "less than expected" before we're ready to break out the (cheap, domestically produced) champagne (er, sparkling wine.)
But in retrospect, understanding that consumer spending is one of the first things to get hit in a recession -- and one of the first things to come back -- may explain why the news that retail spending had fallen only slightly in February helped kick off the current stock market upswing. Investors are desperate for that first sign of light at the end of the tunnel, and they know where they should be looking to see it. But it could still be a mirage.